Comparing EBITDA to Actual Cash Flow
EBITDA (which we call “EBITDUH”) is one of the most highly deceptive and overused financial terms in business and investment finance. The Business Ferret likens EBITDA to a mythical unicorn of finance. To create an accurate cash flow picture, EBITDA cannot be used alone; we need to move from EBITDA to cash flow, ACTUAL cash flow.
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Let’s be sure that we are clear about each piece of this definition.
- “Earnings” means net income from operations before any other income or expense – basically net operating income (NOI).
- “Before interest” is before interest expense but also before interest income. This is automatically excluded when talking about NOI, as is interest expense, so this part of the term is redundant.
- NOI is before “taxes” so again this is a redundancy in the acronym.
- “Depreciation and amortization” expense are both typically included in the operating expenses. Depreciation is sometimes included in costs of goods sold or in both areas.
The term is now really reduced down to NOI plus depreciation and amortization expense or “NOIDA” (we love our acronyms).
EBITDA is considered a place holder for gross cash flow. In the early part of EBITDA’s existence, it was considered an excellent way to find equivalent gross cash flow for one company to the next within the same industry. EBITDA would eliminate the distortions of holding too much cash, or having too much debt, and different depreciation methods employed – such as accelerated versus more conservative straight and higher goodwill due to acquisitions.
This term actually shows a gross NOI from operations. The only other distortion would be officers’ salaries if they were too low or too high so that would need to be adjusted. What “NOIDA” gets at is operational expenses – or core operating expenses – per revenue dollar. But even this would be misleading to anyone who systematically uses the Business Ferret.
How EBITDA is used today is even more problematic: it’s viewed as a good indicator for cash flow. Nothing could be further from the truth. Does EBITDA deserve the bad rap as a cash flow place holder? Yes.
EBITDA as a financial tool is like a pitchfork masquerading as shovel. Defenders of EBITDA speak to its usefulness in ability to carry debt financing (for valuation metrics) making systematic comparisons of one company to another within an industry. If you look at why EBITDA is not a place holder for cash flow then one sees immediately why it does not work for any of the uses above.
EBITDA ignores essential elements necessary for a business to function and to calculate cash flow. Without these essential elements, the business would not function. It is like looking at comparable construction costs for one house to another by only counting the wood and concrete used in each and then drawing conclusions about one house to another. EBITDA ignores all annual working capital changes in the business which can fluctuate dramatically and are typically larger than the NOI.
Without accounting for working capital changes that are different for one business to another – even within industries – businesses would cease to function. Additionally EBITDA ignores the actual capital expenditure needed each year to maintain fixed assets that support the physical infrastructure of the business. These two items are the major determinants of actual annual cash flow for a company.
Of course, we can’t forget taxes. Just because you have a large EBITDA does not mean the IRS is going to be as overjoyed as you are and tell you to ignore the payment of the income taxes for the year. Publicly traded companies average a tax rate of around 21% so this is a big adjustment to ignore before arriving at cash flow.
Using EBITDA as a substitute for actual cash flow is like using a multiple of revenues to determine value of a company – it is just too gross of a figure to really tell one anything much anymore in today’s world of finance. Today’s world of business finance needs to be more strategic and more tactical.
Let’s move from EBITDA to cash flow in business finance – it will not be missed!